Fins1612 Week 2 Tut

2. The GFC is now thought of as having had two parts or phases.

Describe each part or phase and outline some of the measures that have
been taken by governments and central banks in Australia, Europe and the
USA in order to stem the effects of both phases of the crisis on their
respective real economies. (LO 1.1)

The first phase of the crisis occurred during 2007 and 2008. During this time,
financial markets suffered substantial declines as trouble in the mortgage
derivatives markets engulfed some of the worlds biggest financial institutions.
The second phase of the crisis began when the true financial or economic
position of several European countriesespecially Greece, Spain, Portugal and
Irelandbecame apparent. Doubts surfaced regarding the ability of these countries
to meet their obligations to bond holders. Since these bonds were held by banks in
many European countries, fears of a collapse of the financial system were sparked.
Governments around the world have taken some extreme steps to mitigate
the effects of the crisis. In Australia, a large government stimulus package was
initiated soon after the first phase of the GFC. This included the roof batts program
that has attracted so much commentary. In the USA, the government initiated bail-
outs and buy-outs of financial institutions and absorbed billions of dollars of toxic
assets. The Fed cut interest rates to near zero and engaged in a multi-year program
of quantitative easing. In Europe, the bail-outs included not only financial
institutions but some governments with interest rate cuts, bail-out programs and
economic stimulus being managed through the European Central Bank (ECB).

3. Explain why an investor should consider the timepattern of cash

flows and the variability of the cash flows associated with a multi-period
investment rather than simply assessing the investment on the basis of
the total cash flows received. (LO 1.1)
The value of an investment today is not assessed simply on the basis of the total
cash flows to be received in the future.
The time pattern of cash flows is important because cash flows that are received
sooner are worth more than cash flows that are received later.
The variability of the cash flows is important because the greater the variability of
the cash flows the greater the chance that the actual cash flows will be different
from that which was expected. Variability is a reflection of the risks involved in the
investment.
6. Financial instruments may be categorised as equity, debt or
derivatives. Discuss each category. In your answer, make sure you explain
the differences between debt, equity and derivatives. (LO 1.3)
A deficit entity is a borrower or user of funds.
Debt is a loan that must be repaid under the terms and conditions of the loan
contractinterest payments, principal repaid.
The loan contract will specify the timing and amount of cash flowstype and rate
of interest, frequency of payments, maturity of loan.
Equity represents an ownership positionexample, a shareholder is a part-owner
of the corporation in which shares are held.
The equity holder is entitled to share in any profits (losses) that are realised.
Equity has no maturity dateneed to sell asset to realise value.
Derivativesfutures, forwards, options and swaps.
Derivatives are not used to raise funds, but typically to manage a particular risk
exposurefor example, the risk that interest rates might rise on a loan.

7. During the GFC, the funding of longer-term assets with short-term

borrowing was identified as a point of weakness in the operations of
financial institutions. Discuss this statement with reference to the
matching principle. (LO 1.4)
The matching principle refers to the idea that short term assets should be funded
with short term liabilities and longer term assets should be funded with longer term
liabilities and equity.
Many of the notable collapses of financial institutions were characterised, in part,
by a failure to adhere to this principle. In a number of cases, notably Bear Sterns, a
substantial proportion of longer term assets were funded on very short term
liabilities.
This behaviour ensured that these financial institutions were very vulnerable to a
run on their short term funding. When counter-parties refused to roll-over short
term debt facilities, there was not enough equity capital to sustain the operations of
the firm and the longer term assets that had been accumulated.

8. (a) What are the differences between primary market and secondary
market financial transactions?
Primary market transactions relate to the creation of a new financial assetfor
example, a company issues new shares or the government issues Treasury bonds;
new funds being raised
Secondary market transactions relate to the sale and transfer of existing financial
assets; for example, a shareholder sells their shares to another investor and
receives valuetransfer of ownership; no new funds raised.

(b) Why is the existence of well-developed secondary markets important

to the functioning of the primary markets within the financial system? (LO
1.4)
Primary market transactions provides funds for business development and thus
economic growth.
Investors will purchase primary market securities if they know that there is a
deep and liquid secondary market in which they are able to sell the securities at a
later date, if necessary.
Secondary market transactions provide price discovery in that the securities
will be sold at the current market value.

9. Explain the meaning of the terms financial assets, financial

instruments and securities. What is the difference between these terms?
Give examples of financial instruments and securities. (LO 1.4)
A financial asset represents an entitlement to future cash flows.
A financial instrument is a financial asset whose value is represented in paper
or electronic form; for example, Treasury bond, term deposit.
A financial security is a financial asset where there is a formal secondary
market where the asset may be bought or sold; for example, shares, money market
securities such as bills of exchange and commercial paper.

10. Banks are the major providers of intermediated finance to the

household and business sectors of an economy. In carrying out the
intermediation process, banks perform a range of important functions.
List these functions and discuss their importance for the financial system.
(LO 1.4)
Asset transformationwide range of deposit and lending products
Maturity transformationsatisfies different time preferences of savers and
borrowers
Credit risk diversification and transformationcredit risk is with the financial
intermediary, intermediary diversifies across thousands of borrowers
 Liquidity transformationsatisfies short-term preferences of depositors for
access to funds, and longer-term preferences of borrowers for commitment of funds
Economies of scalecost efficiencies, standard documentation, technology
information and product delivery systems.

and proposed legislation on the flow of funds?